Impact of Fed's QE3 is likely to be for short term: Russel Napier, Strategist, CLSA

Russel Napier:Equities are not assets. The problem with the deflation shock is that assets tend to come down faster than liabilities. In very extreme scenario, assets go below liabilities and equities get completely wiped out. Cash flows can come down faster than costs and people have a problem servicing their debt. There are very few equities that go up in a period of deflation or in a deflationary shock. The recent evidence was the post Lehman Brothers era.

In terms of trying to protect yourself and still being in equities, look for equities with a lot of cash and those which pay high dividends. We get some protection there but we may not make any money. The worst equities to be in a deflationary environment are the ones that are heavily geared. This is because those are most likely to go bankrupt when the corporate revenues come down.

ET Now: When do you expect the world economy to come out of this deflation shock and which countries do you think have a chance of getting out of this first?

Russel Napier: It is always assumed that the monetary policy is the only way we could reflate. However, there is another way known as financial suppression. Financial suppression is the state getting into the business of creating commercial credit directly. We can see evidence of that in the United Kingdom. Therefore, it is going to reflate first in West and with people who get directly into the business providing credit for the commercial sector. It is much more likely to be in United States than Europe.

We have an interesting programme in the United Kingdom where the Bank of England is going to be aggressive in effect of becoming a commercial bank and lending money. In terms of the emerging markets, there is some time before we can get to a reflationary situation. This is because the problem for them is letting the exchange risk go. To get aggressive on reflating, the exchange risk will have to go and the problem for that is many of them have borrowed lots of US dollars. So, there are significant complicating factors for EMs in running easy monetary policy.ET Now: If central banks in the Western World continue to print money, do not you expect risky assets like emerging market equities to attract more funds?

Russel Napier: No. There has been and there is a great linkage from US monetary policy into EM when they are in surplus but not when they are in deficit. They are on deficit on the current accounts but most importantly on the capital accounts. Therefore, there is no linkage through. They will be running tighter monetary policy. We have to look out for the devaluation of the exchange risk.

ET Now: Do you think that US can avoid the fiscal cliff?

Russel Napier: I do believe that. There is a basic law which is that a government which can borrow at 2% will borrow at 2% whether that is a Republican or a Democratic government. The only thing that stops the United States government from borrowing too much is the fiscal house in order is a significantly higher yield.

We have seen that already in Europe. Italy and Spain were going ahead with no longer fiscal policy until the middle of last year. The yields went up and any political posturing prior to that about fixing their fiscal deficits became a reality when the cost of borrowing went up. Therefore, if they can borrow at 2%, they will continue to borrow at 2%.

ET Now: What about euro, do you expect it to survive this shock?

Russel Napier: I do not expect the euro to survive a shock. The euro is an experiment and is not yet a fully fledged currency. Within that experiment the adjustment mechanism is via internal prices. In other words, it is deflation in Greece, Spain, Italy and Portugal. Some economies can take it and some cannot. The ones least likely to be able to take are the higher leverage ones.

This is because in the process of watching wages ourselves and corporate cash flows come down, we can go bankrupt. Therefore, any highly geared state can ultimately deal with the deflationary adjustment and the loose states will have to have their own monetary policy if they were to survive and that will mean them leaving the Euro.

ET Now: Do you think it is China which will get the world on its knees? Do you expect some more easing to be announced by China to stimulate growth?

Russel Napier: Yes, I do but the important thing to remember is that for the first time since 1993, China will have a choice. There is an exchange rate and there is an easing monetary policy. If they chose to ease monetary policy, it will have a negative impact on the exchange rate. We have not seen the exchange rate come down since 1994. So, everybody expects an easing and I also expect an easing. However, the nasty surprise for everybody in terms of its impact on global growth, China's competitiveness will be marked deterioration in the exchange rate as part and parcel of that reflation process.